Monday, 25 February 2013

The
crisis showed that the standard macroeconomic models used by central bankers
and other policymakers, which go by the catchy name of “dynamic stochastic
general equilibrium” (DSGE) models, neither represent the financial system
accurately nor allow for the booms and busts observed in the real world. A
number of academics are trying to fix these failings.

Their
first task is to put banks into the models. Today’s mainstream macro models
contain a small number of “representative agents”, such as a household, a
non-financial business and the government, but no banks. They were omitted
because macroeconomists thought of them as a simple “veil” between savers and
borrowers, rather than profit-seeking firms that make loans opportunistically
and may they affect the economy.

This
perspective has changed, to put it mildly. Hyun Song Shin of Princeton
University has shown that banks’ internal risk models make them take more and
more risk as asset prices rise, for instance. Yale’s John Geanakoplos has long
argued that in fact
small changes in the willingness of creditors to lend against a given asset can
have large effects on that asset’s price. Easy lending terms allow speculators
with little cash to bid up prices far above their fundamental value. If lenders
become more conservative, these marginal buyers are forced out of the market,
causing prices to tumble.

Realistically
representing the financial sector would help solve the other big problem with
mainstream macro models: that they are inherently stable unless disturbed from
the outside. This feature is helpful when studying how aneconomy in “equilibrium” responds to
things like a spike in the price of petrol, but it limits economists’
understanding of why economies expand and contract in the absence of such
external shocks. Highly leveraged financial firms with portfolios of risky
assets are bound to upend an economy every so often. Having banks in models
would generate shocks from within the system.

The
world’s big central banks are interested in these new ideas, although staff
economists are reluctant to abandon existing “industry-standard” models. If any
central bank is likely to experiment, however, it is the European Central Bank,
thanks to its “two-pillar approach” to assessing the risks of price stability.
The ECB pays as much attention to “monetary analysis”, which includes things
like bank lending and money creation, as to “economic analysis”, which is more
concerned with things like inflation and joblessness.

Friday, 22 February 2013

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